Big Pharma’s stalled R&D machines

One factor forcing Big Pharma to rethink its business model is the huge number of patents that are set to expire over the next five years. As patents run out on blockbuster prescription tablets like Pfizer’s $12 billion-a-year cholesterol medicine Lipitor and AstraZeneca’s $5 billion heartburn pill Nexium, cut-price generics are sure to rush in and slash margins. Between now and 2015 products with sales of more than $142 billion will face copycat competition, according to IMS Health, the leading global supplier of prescription drug data. It is the biggest “cliff” of patent expiries in the history of the pharmaceuticals industry.

Add in tougher regulatory hurdles and a brutal squeeze on healthcare budgets as cash-strapped governments push austerity programs and it’s little wonder that drug companies are cutting back and shifting focus. The strategy so far has been to buy promising new drugs from outside developers and boost investment in the relative safety of non-prescription consumer products. Big drugmakers are also moving into new markets — with Asia at the top of everybody’s list. It all adds up to a redesign of the multinational pharmaceutical company. In the 21st century, says Isaly, Big Pharma will primarily be a distribution business.

However, the existing/historic R&D model does not seem to work effectively:

The problem is, Big Pharma doesn’t have nearly enough new drugs in the pipeline to replace all those it is about to lose. Since 1950 — virtually the dawn of the modern era of medicine — a total of 1,256 new drugs have been approved by the U.S. Food and Drug Administration (FDA). But the industry today produces roughly the same number of new medicines that it did 60 years ago.

Ten years ago there was a lot of hope that process-led research systems would industrialize the hunt for new drugs. But that optimism may have been misplaced. A spike in drug approvals in the mid-1990s, it turns out, was not the result of any fundamental improvement in productivity but largely down to the FDA clearing a backlog of applications after the introduction of a new system under which companies paid “user fees” to help speed the process.

Despite pouring billions into research — more than $65 billion last year in the U.S. alone — the number of new drugs launched annually has fallen 44 percent since 1997, according to CMR International, a Thomson Reuters subsidiary.

It appears that the PE ratio of pharmaceutical firms have dropped below that of consumer goods companies such as P&G. Instead of figuring out a way to make R&D more effective, the industry seems to want to move towards a more consumer goods model and cut R&D as much as possible:

The move to cut R&D, he says, is one of the most profound changes in the industry in decades. Some firms are pulling back from problematic areas like depression, where proving the value of new medicines in clinical trials is fiendishly difficult. Lack of progress in this field is a prime reason behind Glaxo’s decision to cut research in Verona. Other firms are cutting back in areas that used to be their bread and butter. Pfizer, for instance, is trimming research into cardiovascular drugs and AstraZeneca is ending discovery in psychiatric medicine. Instead of pouring money into R&D themselves, drugmakers are turning to smaller firms, outsourcing routine research functions and even buying in smart blue-sky discovery work.

However, the large gross margins can not be sustained in a non-R&D discriminated business. Hence the industry seems to want to outsource R&D to contract research organizations (CRO):

They’re also happy to pick up Big Pharma’s leftovers. Glaxo, for example, is negotiating to sell its Verona site to a U.S.-based CRO called Aptuit. Parexel International Corp, which is based in Boston and conducts clinical trials for drugmakers around the world, is busy hiring hundreds of new staff — many of them refugees from Big Pharma. “It’s a brain shift,” says Parexel’s chief executive and founder Josef von Rickenbach. “The rate of outsourcing has continued to tick up pretty much every year across all clinical trial activities.”

Does it not mean that the fundamental problem is not necessarily that R&D is ineffective, but that is costs too much? R&D will be not outsourced to CRO who can maintain lower costs and higher efficiencies by leveraging economies of scale. My question is: How large does a company have to be for economies of scale to be no longer make a difference? What does a company give up in strategic / competitive advantage by outsourcing critical R&D?